Wednesday, September 26, 2012

Does This Card Ever Get Played Any More?

It is a story all too common today that our society is practically anesthetized to it: Securities laws repeatedly failing to protect the trusting investors from unscrupulous money managers.

MF Global is a little different twist. Unsuspecting trading clients are bilked to pay for the highly leveraged “cowboy” trades of their very own clearing house which turns out to be nothing but a hedge fund in disguise.

At a bankruptcy filing date MF Global had a $40 billion balance sheet and a paltry $1.4 in equity. Its annual revenues were only $2.2 billion. When you include up to $16 billion in off balance sheet liabilities you get to a leverage ratio of about 40 to 1 -- not a lot of room for errors.

The Trade Structure

The trades that “brought down the airplane” were quite prosaic in the arcane world of hedge fund trades. It was a simple highly leveraged “carry trade”. Corzine bought $6.3 billion of the sovereign debt of Southern European PIIGS countries and financed it through a repurchase agreement or in trade jargon, “repos”.

The purchased bonds had a much higher coupon payment rate than the loan rate that MF Global would pay to the “repo” lender hence MF global would be making a guaranteed spread or “carry”.

When (if) the bonds ultimately matured and repaid 100% of their face amount, then MF Global contractually would use the bond proceeds to buy back or “repurchase” the bonds from the lender, thus repaying the “repo” loan.

For example, JP Morgan (JPM) or Bank of America (BAC) took in Spanish bonds as collateral that MF Global had just purchased and made a loan that matured concurrently with the bond maturity date. If the bonds were $1 billion maybe JPM or BAC would loan on the order of $980 million and MF Global would come up with $20 million.

The $20 million or, in this case, 2% of the purchase price is the “haircut” that JPM wanted from the purchaser. The “haircut” or margin required is a negotiated amount between borrower and lender. To a highly creditworthy borrower the “haircut” may even be 0. That is the lender would lend all the purchase money.

The interest rate environment of 2011 when these trades occurred is not significantly different than the rate landscape of today. JPM probably lent on a floating or fixed LIBOR based formula, something like LIBOR +40 basis points or just Libor +40 as it would be quoted. As short term LIBOR was less than 25 basis points (or .25 of 1%) then all in all, MF Global borrow rate was most likely something less than 1% (.25 +.40=.65 of 1%).

Say the rate on the Spanish bond was 5% and Corzine was able to purchase at a 10% discount to par (100) or 90% of face value. Then the “carry” would be the 5.55% coupon (remember the discount) less the .65% loan rate or 4.90%. At maturity if the bond paid in full as planned then using extreme leverage the return potential quickly gets into triple digits.

The game plan that Corzine had designed was conceptually sound. While he was admittedly purchasing the “junk” credits of Spain, Portugal, Italy, and Ireland the reality was, at the time, there had never been a Eurozone sovereign default and the zeitgeist was to preserve the “union” at all costs.

Further, only short duration bonds, presumably with maturities of two years or less, were bought. This greatly reduced the risk of the trade. So as bonds would mature, presumably Spain and the other countries would simply “roll over” or sell new bonds to retire the maturing ones.

Worse case, the assumption was the ECB would step in and purchase bonds through EFSF or ESM or the direct bond purchase program in place.

All was copacetic until the plane hit some severe unanticipated thunderstorms, with lots of lightning. As part of the “repo” agreement, the amount of margin or “haircut” was subject to be increased as the price of the collateral (the bonds) fluctuated and were “marked” to the market on a daily basis or if the credit of the underlying borrower (MF Global) deteriorated.

On October 24, 2011 Moody’s, due to the European exposure downgraded MF Global debt to one level above “junk”. One day later MF Global reported a $191 million quarterly loss. The following day, the 26th, Moody’s hammered Corzine’s firm with a further two notch downgrade placing the firm at Ba2, or in solid “junk” territory.

Net, Net, MF Global was now repeatedly being called for more and more margin as both their company credit and the prices of the European bonds deteriorated rapidly. It was a liquidity crisis. With credit lines completely used up -- where was there left to turn?

Crossing The Line

On October 26th and the ensuing five days before the bankruptcy, who did what, when, and why, on whose instructions is a main crux of the issue.

On the 26th $615 million of segregated customer funds were approved for transfer by assistant treasurer Edith O’Brien from accounts at JP Morgan. This transfer was supposed to be a loan that was to be repaid by the end of the same business day which would have been legal.

Needless to say the funds were not returned. On the 28th per e-mail trails, Corzine ordered a $175 million transfer to cover an overdraft at JP Morgan.Ms. O’Brien tapped another $200 million of customer funds to meet this obligation. We know there were many more transactions wiring customer funds out of what were supposedly statutorily segregated at the broker dealer level.

Hundreds of millions of the customer money was funneled to an MF Global UK subsidiary. Ultimately, MF Global Inc. bankruptcy trustee James Giddens found as much as $1.6 billion of misappropriated customer funds.

Nobody Knows Anything

“I simply do not know where the money is” Corzine droned at a Congressional hearing. OK, if you don’t then who does? There is some evidence now that this money filching scheme began as early as August 2011 over two months prior to the October 31 bankruptcy filing. Mid –level employee Edith O’Brien pleaded her Fifth Amendment rights when she was called to testify about her role in the scam.

In what was surely dozens of illegal transactions, miraculously there is a dearth of memory cells purporting any knowledge of the purloined funds. Between the CFTC, the CME, the SEC, and the Justice Department investigations, astonishing and incredulous am I that none of these agencies could piece together enough forensic accounting evidence to levy even a few indictments against Corzine and his henchmen.

Lurking conspiracy theorists say MF Global was a client of Eric Holder and his deputy AG Lanny Breuer’s former law firm of Covington and Burling and Corzine is a huge Obama fundraiser so therefore any probes will be superficial and inconclusive.

Well, that has certainly been the headlines in recent days -- no criminal charges are expected. I guess you’re not paranoid if they’re out to get you.

ContributorFrom all accounts Corzine was a very hands-on manager. He relentlessly walked the trading floor and was chief architect for all the sovereign debt positions.

He is an expert on the asset class; he used to trade sovereigns back in his Goldman days. Consequently, because of the extreme leverage employed even small moves in interest rates could mean big margin calls. Any person with any attention to detail would be constantly monitoring all trades and calculating exactly what margin may be due and where the money to fund them was going to come from.

Corzine did not get to be head of Goldman Sachs, a senator and governor of New Jersey without being an very bright, attention to detail-oriented person.

Anytime a big margin call came in, who do you think was notified first? Ultimately whose decision was it as to where the money to meet the call was going to come from?

It’s perplexing why can’t regulators trace over a billion dollars in wire transfers? “Judicial Watch” got so tired of asking they have filed suit under the FOIA requesting all documents relating to missing customer funds.

Trustee Giddens is so angry about desultory regulators; he vows to seek state venues for criminal action. So unless Mr. Corzine received some unclosed head blow which resulted in a rapid cognitive decline, the odds are, to me, thin indeed that he remained ignorant of MF Global machinations.

The sad thing is that Corzine just ran out of time. Most of his European bets have already been refinanced and paid off in full. As they say in accounting, it was just a “timing difference”. Except in this case someone misappropriated $1.6 billion of money that didn’t belong to them.

Will Mr. Corzine realize his next dream of starting his own hedge fund or will he get to spend the next decade or two doing what I think he should be doing, time, and preferably not at some “club fed”.